TGS Nopec - Wide-Moat Natural Monopoly With 50% Upside In A Year

(Editor's Note: TGS NOPEC trades under the ticker TGS.OL on the Oslo exchange with average daily volume of ~540 million Norwegian Krone.)

TGS NOPEC (OTCPK:TGSGY) (OTC:TGSNF) has everything value investors could dream about:

- Natural monopoly with pricing power;

- Wide-moat, asset-light and flexible business model;

- Management with proven track record, low compensation and significant holdings in the company;

- Long history of excess returns, with ROE=22%, BV growth of 20% over 10 years;

- High profitability with EBITDA margin of 80% and net margin of 30%;

- 4-5% dividend yield and share buybacks.

Due to Oil & Gas industry cyclicality the company is currently out of favor with investor. This creates a buying opportunity that will potentially deliver 45% return in one year and 100% in 3 years.

Business Model

TGS business model is not very straight forward, but it is nicely explained in their 2013 Capital Markets presentation (here). I will cover it briefly.

TGS provides multi-client seismic data and related geoscientific products to the oil & gas industry. Exploration companies use this data (i.e. seismic mapped underground geology) and products to determine where to drill. According to TGS presentation: "Only seismic offers both the depth of penetration and the resolution needed to explore for oil & gas." Thus, exploration companies are in a way forced to acquire such seismic data and there are two ways to do this:

- Hire a seismic contractor. In this case exploration company initiates, drives and funds the project (fully covering contractors expenses + profit margin). Company retains the rights to survey data and contractor gets paid the agreed fee. This method can be fairly expensive for E&P companies, especially when surveying to-be-licensed areas.

- Buy data license from multi-client (MC) data provider such as TGS. In this case contractor together with E&P company identifies opportunity. Then contractor manages and controls the project. The risk for contractor is reduced by securing customer commitment (pre-funding) in return for reduced cost to access the data. Contractor retains full ownership of seismic data and is able to relicense it to multiple clients.

The multi-client option tends to be cheaper for E&P companies and more profitable for contractors as same data is resold several times and pre-funding usually covers c. 50% of the company's multi-client library investments. Thus it seems like a win-win situation for TGS and for its clients.

TGS does not own any vessels and secures all seismic acquisition capacity from external sources (e.g. at the end of 2013 the company had four 3D vessels and two 2D vessels on charter hire), thus maintaining an asset-light, low-overhead business model. More importantly investment decisions are not driven by vessel utilization, so the company can simply forgo any projects below required IRR threshold.

Company background

TGS NOPEC was formed in 1998 following the merger of TGS Geophysical Company (US based with multi-client library in North America and West Africa) and NOPEC International (Norway based with multi-client library in North Sea, Australia and Far East). After the merger, TGS continued to expand through outright acquisitions of seismic data as well as carrying out pre-funded surveys for its clients. During the last 15 years TGS also acquired a number of seismic technology companies allowing it to stay on the leading edge of industry development. However, the large majority of capex was spent on the main asset - TGS multi-client library.

Company is currently listed in the Oslo stock exchange (under ticker TGS.OL) and trades at a $3bn market cap with zero debt. It is among the 25 most liquid stocks in Oslo. Although it seems to be listed in OTC market as well, there is hardly any liquidity, so would recommend to carry out any transactions in Oslo exchange (possible through IB).

Quality management with significant holdings in the company

Company is run by Robert Hobbs, who became CEO in 2009. Prior to joining TGS, Robert held top management positions in Worldwide Geoscience with Marathon Oil Company and Veritas DGC. His background is mainly in geology and geophysics, so he likely understands the business bottom up. Robert owns 30,000 (total holding of $0.9m) shares of TGS and was purchasing shares in 2013 at prices of 160-210NOK. CEO's total compensation for 2012 was $0.3m, out of which $0.23m is performance related (2012 was the best year in company's history). So his holding in the company is 10x larger than base salary and 3x larger than total compensation.

TGS's previous CEO Henry Hamilton ran the company for 14 years between 1995 and 2009 and currently holds the position of Chairman. His background is also in geophysics. Henry Hamilton holds 1.3m shares (total holding of $40m or 1.3% of the company). The Chairman gets only $215,000 for his service, which is negligible compared to his holding in the company.

Other board members and top management also have material holdings in the company and purchased shares last year at prices of 170-180NOK. Salaries of the board members are only $50,000 annually and additionally they are awarded $50,000 in restricted shares, which cannot be sold for 2 years.

So overall management and board compensation seems low (keep in mind that TGS is a $3bn market cap company) and aligned with shareholders' interest. Moreover, management and board continue to add to their holdings by purchasing shares in the market in some cases for prices higher than the current one. Shareholders' structure is widely dispersed, with the 20 largest shareholders having under 50% of the company. The largest owner (9%) is Norwegian Sovereign Wealth Fund, other shareholders include major financial institutions across US and Europe.

Dividends and buybacks

With Robert Hobbs coming on board a dividend program was introduced aiming to distribute any excess free cash flow to shareholders. $400m (14% of current market cap) was distributed in dividends and another $40m in net share buybacks over the last 4 years (earlier distributions were mostly through buybacks). Dividend yields have ranged at c. 3.5%-4%.

Additionally, $30m share buyback was initiated in Feb 2014, so far the company already purchased 35,000 shares. Also a buyback of $5m was carried out in Q4 2013.

Historical financial performance

As can be expected from entrenched management and asset-light, wide-moat business model, historical long-term (2003-2013) performance is outstanding:

- Revenue has grown at a CAGR of 20% (from $137m to $883m);

- Book value of equity has grown also at 20% (from $196m to $1293m);

- Average EBITDA margin 79%;

- Average net profit margin stands at 28% and never dipped below twenties;

- Average ROE is 22% (with 14% being the lowest reading back in 2003).

Moreover, this performance was achieved with 70% of the balance sheet funded by equity and without using any debt (negligible amount of debt was fully repaid in 2009). Business has performed profitably also during the crisis - there was only a slight dip in net profit (-18% YoY) during 2008, but then in 2009 net profit shot up +43% YoY. Company generated strong cash flow through the cycles (both high and low oil & gas prices) with significant dividend capacity also when the cycle bottoms out.

Clearly this business seems to have a moat and I believe it comes from continuously growing multi-client data library.

Global data library

Current extent of TGS seismic data library is shown in this picture.

Source: TGS 2013 Capital Markets presentation

TGS is continuously adding new data to its multi-client library through outright acquisitions of seismic data as well as carrying out pre-funded surveys for its clients. Clients on average prefund c. 50% of the investment required to carry-out the seismic survey. So the first client gets data twice cheaper than it costs TGS to produce, however the company more than recoups this 'initial loss' from sales of the same data to other clients (TGS calls these 'late sales', and they make up c. 70-80% of revenue). Over 10 years TGS average multi-client projects return 2-2.5 times cost as shown in the chart.

Source: TGS 2013 Capital Markets presentation

TGS is able to maintain these high returns on investments through careful selection of projects the company undertakes and varying pre-funding requirements. The projects where return on costs expectations are lower (already awarded acreage, onshore areas, fewer potential clients) there is a higher pre-funding requirement (70-120%) and for projects with higher expectations of multiple sales, pre-funding is adjusted downwards.

Wide Moat

There are several ways in which multi-client library creates a wide moat for TGS. Firstly, the company has a natural monopoly on the acreage it has already mapped. With ability to resell seismic data multiple times it deters competitors from mapping the same area - hardly any E&P company would be willing to invest in a new seismic survey when it can buy readily available data from TGS cheaper. This gives TGS pricing power - as long as it resells data below the cost of contracting new seismic survey, exploration companies will be willing to buy it from TGS. Thus, lack of competition coupled with pricing power and practically no variable costs to resell data creates excess profitability (ROE of 22%). TGS outperformance is clearly illustrated in this EBIT margin chart (competitors include CGG, Fugro, Geokinetics, ION Geophysicxal, PGS, Western Geco and GGS):

Source: TGS 2013 Capital Markets presentation

TGS has spent $2.4bn in the last ten years building the database (that excludes anything spent between 1981 to 2004 as well as build-up of extensive knowledge of the industry), so any wanna-be-competitor in the same geographical locations would have to invest a similar amount. This creates a material financial barrier to entry. Moreover, TGS capex was c. 50% pre-funded by exploration companies, but a new entrant would have to invest the whole amount by itself. Thus even with huge capex the competitors will not replicate the same returns on capital as TGS. And so the natural TGS monopoly and excess returns.

When it comes to surveying and mapping new areas, there is also certain degree of moat in TGS client relationships built over the 30+ of businesses as well as its technological expertise. TGS is in a sweet spot of providing a critical but cheap (compared to overall budgets) input for E&P projects. Thus clients are likely to be less sensitive to price of seismic surveys and rather prefer to work with the company they already have experience with. However, this moat is not as entrenched as natural monopoly on the acreage already mapped by TGS - other seismic surveying companies which also boast about their client relationship and technical expertise.

Nevertheless this does not mean that TGS's monopoly position will dissipate as the current data in the library gets outdated. With every new multi-client survey, TGS keeps adding to its seismic library. So unless for some reason (I cannot foresee any at the moment) clients stop hiring TGS, its monopoly position will only strengthen in the future.

Understated book value of multi-client library

TGS capitalizes the direct costs of surveys as investments in the balance sheet and amortizes them over 5 years (including the first year - WIP). Amortization schedule is very conservative, with 40% of book value amortized during the first year (although late sales make up 70-80% of the revenue). At the end of the fourth year after survey completion, each survey is fully amortized, however it continues to generate cash. On average 15-20% of revenue each year is received from fully amortized portions of the library, and this revenue comes at a high net margin (there is literally no additional variable costs to provide client with access to downloadable data on the website).

The net book value of the library currently stands at $758m, however, I estimate the actual book value to be c. $1.5bn. My calculations and assumptions are below:

- late sales (seismic data already in the library) are on average 70%-80% of annual revenue. TGS projects $910m sales for 2014, out of which $700m will be late sales.

- Late sales from the vintages current library in the library will decline gradually by $100m each year, so that after 4 years it still generates 20% of annual revenue, in line with historical record.

- These late sales come at a net high margin of 70%, the only expense being income tax of 30%.

- Net profit discounted 10%.

Although $1.5bn is only a very rough estimate it gives a clear indication, that current book value of multi-client library is significantly understated.

Another way to estimate 'true' book value, would be to multiply current book value by 2.0-2.5 (TGS average return on costs). This leads a similar result of $1.5-$1.8bn.

Outlook going forward

Overall seismic market is expected to increase going forward and the main growth will be driven by multi-client type of spending. This growth expectation is based on the premises of:

- Declining global oil and gas reserves as more oil is produced from existing reserves than currently being discovered. Thus increasing investments are required just to maintain reserve replacement;

Source: IEA World Energy Outlook 2011

- Political instability and closed markets reduce available acreage in known oil producing areas, putting more pressure on exploring new frontiers.

- Companies producing and exploring shale plays continue to seek high quality well-bore based information to guide their petrophysical analysis of unconventional plays.

- Seismic spending has been gradually increasing over the last 10 years.

Source: TGS 2013 Capital Markets presentation

- With E&P companies emphasizing cost controls over the last years (have a look at recent news headlines for Shell, Total and etc.), cheaper multi-client data should gain market share over contracted surveys as clients are increasingly comfortable accessing their geoscience data through multi-client method.

Source: TGS 2013 Capital Markets presentation

So company has a long-term tailwind from the oil & gas industry trends, and being the most cost-efficient and flexible player in the market, TGS should profit from these trends immensely.

2013 was a slight setback in the company's financial history with both revenues and profits experiencing declines of c. 5% YoY (vs. rapid growth previously). This was largely driven by overall depressed moods in commodity markets and flattened out E&P spending.

However, at the end of 2013, the company reported the largest backlog ($280m) in its history and announced few new multi-client surveys. Thus there seems to be an uptick in the industry and outlook for 2014 is bright. Management expects revenues of $870m-$950m which should result in net profit of $280m, EBITDA of c. $800m and FCF to equity of $210m:

EBITDA of $800m, less

- cash taxes of $130m

- multi-client capex of $430m

- less maintenance capex of $30m

FCF to equity = $210m

This would mean ROE of 22% and FCF yield of 7%, most of which is likely to be distributed as dividends or through buybacks.

Valuation - potential 45% return in one year

Rather than assigning numerical value to the company's value I prefer to think in terms of future returns TGS could generate. If for the next few years TGS continues to grow book value at historical average (20%) while distributing $100m in annual dividend (compared to $140m in 2013), then in 3 years time situation would look like this:

- Book value of $2.2bn and applying current 2.4 P/BV multiple, we get market cap of $5.3m;

- Total dividends paid $0.3bn;

- This results in total investor return of 80% within 3 years.

However, I believe this valuation to be on a conservative side. It does not include any multiple expansion, which I believe will happen when the market gets over slight decrease in revenue in 2013 and investors realize the bright future lying ahead. TGS was trading at P/BV multiples of 2.7-2.8 in 2011 and 2012. If market re-rates the company to the same multiple in 3 years, investors will realize return of 110%. Besides, as noted earlier, the current book value itself is undervalued by c. $0.75bn providing boost for P/BV multiple expansion.

Higher P/BV multiple could easily be realized within one year since 2014 performance is projected to be quite similar to the one seen during 2012 (when higher multiple was applied by the market). In this case, investors would get 45% return in one year.

Why the opportunity exists?

The main issue has to do with cyclicality in the oil & gas industry. BP oil spill, perceived riskiness of off-shore drilling and shale oil/gas revolution have put E&P industry and related servicing companies out of favor with investors. During the last 3 years S&P index tracking E&P companies decreased by 5% annually, whereas overall S&P market increased by 13% annually (18% underperformance annually). The same can be observed looking at returns offered by major Oil & Gas producers, which are on average trading at P/E=10 with dividends yields higher than 5% (taking buybacks also into account).

However, we seem to be close to the bottom of the cycle. As write-offs resulting from previous periods of over-investment are digested by the industry, investors will acknowledge value of cheap E&P companies, especially with the backdrop of significant overvaluation in other industries. During the last half a year share prices of E&P majors have already started to pick up.

On TGS specifically, slight (5%) revenue decrease in 2013 (as well as lowered guidance during the year) had an impact in how market perceives the company and its future growth possibilities, however it was just a temporary setback, with revenue projected to grow further in 2014. Overall TGS financial performance does not appear to swing in full cycle with the rest of E&P industry (e.g. profit dropped only 15% when price of oil decreased a few times back in 2008-2009) but share price seems to be more sensitive to industry trends. This creates great buying opportunity for investors who understand and appreciate TGS's value.

Risks

- New technology appears allowing to detect potential drilling places more effectively and accurately than currently employed seismic methods, making TGS's multi-client library obsolete. Although this is a threat, I view TGS as first adopter of any potential new technology, as the company does not own and therefore is not fixated on any seismic equipment or vessels and can switch easily. Obviously, new technology would still have an effect on usefulness of TGS's multi-client library. However, the switch would anyway be gradual, and TGS is well positioned to build a new library based on this new technology, while still receiving positive cash flows from existing seismic business.

- Negative investor sentiment towards E&P industry continues. In this case TGS's valuation (multiples) with regards to book value / cash flow / profit will remain unchanged, however company will still continue to increase profitability and book value. Thus, even without multiple expansion share price will go up reflecting improving fundamentals.

- Oil and gas companies significantly reduce exploration scale (potentially due to China hard landing). I view this as rather unlikely or it would be just a temporary setback for reasons explained in long-term outlook section.

By New Capital

Source:http://seekingalpha.com/article/2058533-tgs-nopec-wide-moat-natural-monopoly-with-50-percent-upside-in-a-year